Current Trends in Partner Compensation

(Editor's Note: This article was excerpted from
a presentation made to the Northern California Association of
Defense Counsel on May 20, 1994. Several of our firm's
principals, including John P. Weil, John D. Moore and Joseph R.
Jacques participated in the seminar. We welcome your questions
and/or comments on the article.)

The significance of
compensation in the overall operation and success of a law firm
can be summarized as follows: 1) Compensation is one of the most
significant factors and one over which you as members of your
firm have a great amount of control; 2) Other important factors
include: being in the "right" field of law for the
time, geographic location, and having the flexibility to adjust
firm size for general economic conditions.

The objectives and benefits of a proper
compensation system can be summarized as follows: 1) Promotes
harmony among the partners because they feel they are fairly
compensated relative to each other; 2) Minimizes dissatisfaction
with compensation and departure of valuable partners; 3) Is
attractive to capable senior associates so that they wish to
become partners in your firm; 4) Provides an incentive for
productive partners to stay with your firm to normal retirement
age.

Partner compensation is affected by more than
just a firm's specific compensation system for its partners.
These factors include: 1) General economic conditions and
government regulation; 2) Specific economic trends affecting the
legal profession; 3) Compensation of associate attorneys,
paralegals, and support staff; 4) Trends in advancement to
partnership and establishment of partner "classes"; 5)
Retirement obligations of the firm.

One of the most significant changes we as
consultants have observed in the legal profession has been what
we refer to as the "maturing of the marketplace for legal
services." Briefly we can define "maturing of a
market" as a change in the balance between service demand
and the number of service providers the point where the service
providers eventually balance or exceed the demand for their
services. Let's look at some statistics.

In 1972 there were approximately 350,000 lawyers
in the U.S. The American Bar Foundation estimates that by the
year 2000, there will be 1,000,000 practicing attorneys. This
translates to having one lawyer for every 572 persons in the U.S.
in 1970 to having one attorney for every 275 persons by the year
2000. Literally a doubling of the relative number of lawyers from
1970 to 2000.

We remember times when law firms grew like topsy.
Most of our clients wanted help to become more efficient in
handling ever-increasing workloads. Any associate who had
reasonably good legal skills and was willing to work would most
likely make partner. Associates were not encouraged (or were even
discouraged) to do business development because the partners in
many firms had too many lucrative and important cases that needed
handling.

Firms grew rapidly resulting in partner/associate
ratios which provided ample income for the partners. There was
enough income so that even relatively low producing partners
could be well paid. Retirement benefits for the relatively few
lawyers who retired during this period often were exceedingly
generous.

The 1970's and 80's also witnessed a rapid
escalation of law firm overhead. Overhead per lawyer in Calif.
ballooned from $31,000 (40.59%) in 1976 to $144,000 (47.8%) in
1992 led by substantial increases in such items as office rent,
staff salaries, office equipment, and malpractice insurance.

Favorable law firm economics also resulted in a
bidding war for top law school graduates. Even though this took
place mainly on Wall Street and with major metropolitan firms,
its effect radiated down to small and medium-sized firms in most
every legal field. Average starting salary 1977=$18,000;
1992=$50,000.

Thus, starting salaries for newly hired lawyers
in private law firms increased 178% in the 15 year period from
1977 to 1992. At the same time compensation of partners increased
only 138% from $64,700 to $154,200. Among the partner ranks, the
most senior group (25-29 years of experience) saw a mere 118%
increase in compensation from $88,450 in 1977 to $192,500 in
1992. This is data for the entire U.S., not just California.
While the foregoing changes occurred, the CPI increased 131.5%
from 1977 to 1992 [60.6 to 140.3].

Can we conclude from this data that average
partner income approximately kept pace with inflation - a 138%
increase in U.S. income compared with an 131% increase in the
consumer price index? The answer is "not exactly". In
1976 average client hours worked by U.S. law firm partners was
reported at 1,557 hours. By 1992 average client hours worked by
partners had risen to 1,721, an increase of about 10%. Thus,
average partner income has kept up with the CPI but lawyers have
had to work harder and smarter to keep up.

There was still another notable aspect to law
practice prior to the 1980's. We saw relatively little movement
of capable senior lawyers among firms. Perhaps
"raiding" was considered "ungentlemanly" and
many firms had no need to entice "top producers" away
from other firms. Oh how things have changed!!

The maturing marketplace for legal services has
resulted in the following: 1) Heightened awareness for the need
to "market" or "sell" a firm's services; 2)
Has caused firms to abandon traditional seniority oriented
compensation systems in favor of more performance oriented
compensation plans; 3) Given more leverage for compensation to
partners who are rainmakers; 4) Has facilitated the ability of
capable lawyers (especially those who control books of business)
to change firms if they are unhappy; 5) It has lengthened the
service time for associates to become partners and has (in some
instances) raised the qualifications for partnership; 6) It has
caused some firms to set-up classes of partners and/or to
establish permanent non-partner professional positions; and 7)
Caused a review of retirement benefits in some firms.

In addition to the maturing of the legal
marketplace which we have just described, general economic
conditions during the past several years have not been very kind
to lawyers. The insurance defense business generally has suffered
along with such other legal fields as real estate, mergers and
acquisitions, and corporate transactional work. There has been
increasing pressure by many of your clients for you to hold down
rate increases, and to absorb or reduce certain costs which
traditionally have been passed through to clients.

Competition has become fierce with frequent
strong courting of your clients by competitor law firms or
break-away groups. Your type of practice may be particularly
vulnerable due to the nature of your clients and the pressure
which is exerted on the people who give you business to hold down
legal fees and expenses. That's our impression of the general
trends we see in your business. Now, let's look at some trends
related to lawyer compensation and thus, partner earnings.

Starting salaries for new lawyers have leveled
off. Above we reported that the average starting salary for new
attorneys was $50,000 in 1992. The 1992 average was the same
which was reported for 1991, 1990 and 1989. Thus, during the past
four years there has been little or no increase in starting
salaries. Today's law school graduates are being forced to
compete with more experienced lawyers who have lost their jobs
due to layoffs and cutbacks.

For many years, the rapid acceleration of
starting salaries drove up other associate salaries. The pressure
mostly is gone. Unless an associate has unusual abilities and
connections, the threat of losing him/her due to perceived
compensation inequities are much diminished in today's legal
market.

For many firms, lengthening the service
requirements for partnership has helped to increase or maintain
partner income in today's competitive legal world. We always have
noted considerable disparities in the length of time it took to
become a partner in various law firms. We used to observe that
the average small to medium-sized firm - say 10 to 25 lawyers,
would have a 5 year service requirement to be eligible for
partnership. Some smaller firms would consider an associate after
4 years and large firms typically had a 6 or 7 year service
requirement.

During the past few years, we have seen a
lengthening of these service requirements by about 1 1/2 to 2
years. Six to seven years now is the norm for smaller firms with
larger firms requiring up to 9, 10 or even 11 years service.
Naturally, all of this changes for the associate with unusual
talent in the way of client and business development. The time
truly has come in the legal profession where the ability to
attract clients and new business is a most important factor in
making partner and obtaining a relatively larger share of the
income pie. In fact, we have seen a few instances where,
regardless of other capabilities, an associate must display a
willingness and some ability to develop new business in order to
be made partner.

What then happens to associates who don't have
this ability? Or others who have good legal skills but are judged
incapable of carrying out the total responsibilities of a
partner? In recent years we have seen some trend in the Western
United States law firms for creating "permanent
associate" positions, but we can't say that this trend is a
strong one. However, it definitely makes sense in some instances.

Consider two examples: a talented lawyer who
strictly wants to work 8 to 5 and their nature of work permits
this; a senior lawyer who may have retired from a corporation.

In recent years we have seen considerable
interest by some firms (usually larger ones) in exploring the
merits of two-tier or multiple tier partnerships. However, here
again we would not say that this has become a "trend".

Mostly we see "non-equity" partners, or
an intermediate step (2 years). For those of you who wish to
explore such a structure, we would suggest that you consider the
following aspects of working in a law firm: 1) Capital
contribution - non-equity partners (are they really partners?);
2) Status (how are they presented to the public and your
clients); 3) Income (less) but why need separate
"class" for this?; 4) Voice in management; 5)
Retirement benefits; 6) Liability.

Who are the intended beneficiaries of a multiple
tiered partnership? Can these benefits be obtained in the
framework of a regular partnership? If yes, which partners go to
a tiered arrangement?

Before we proceed to discuss the trends in how
income is divided among active partners, lets briefly look at
trends in retirement benefits as this too is part of the
compensation picture.

We can report to you that there is a definite
trend toward the reduction of retirement benefits or outright
elimination of such benefits in some firms. The reasons for this
are as follows:

1) Changing demographics are giving rise to
potentially large unfunded retirement obligations. Reluctance of
younger partners to pay these benefits; 2) Diminished need of
lawyers for retirement benefits due to their own build-up of
Keogh plan assets or in similar corporate type qualified pension
plans.

How much money are we talking about? Before the
current trend set in towards reducing or eliminating retirement
benefits, the most common retirement benefit we saw in law firms
was one year's income for the retiring partner. This varied
between a low of say 3 month's income up to 2 1/2 years' of
income. But one year was typical, so that on today's scale of
partner earnings you may have been talking in the $200 to $300K
range. Potentially, this may be quite a loss for partner's whose
firm's are phasing out retirement benefits.

If future, unfunded retirement obligations are of
concern to your firm you may want to explore some alternatives,
such as paying off these obligations currently on a present value
basis. Alternatively you may want to at least put some
restriction on total annual retirement payouts in your
partnership agreement. (Editor's Note: If you don't have such a
clause now, and wish to consider such a step, give us a call and
we'll be pleased to send you some sample language of such a
restricting clause.)

So far we have talked about peripheral
compensation issues. Now lets talk about trends in compensation
arrangements for active partners. The main trend here has been a
movement toward paying increased attention to partner performance
and adjusting compensation commensurately. And quite frequently,
we hear of firms which actually have terminated or separated some
of their presumably "unproductive" partners.

During the past ten years, we as consultants have
been called on quite frequently to assist firms in changing from
compensation systems which were heavily oriented toward seniority
to systems in which partner performance plays a much grater part.
We feel confident in asserting that many of your firms probably
have made this type of change in your partner compensation system
in recent years.

When we entered the legal consulting business,
there were many firms which had essentially seniority based
systems. Many were not as strictly defined in terms of
progression as a lockstep system, but they were seniority based
systems - that is a partner's length of service with the firm
carried great weight in determining compensation. Other factors,
namely productivity and business generation, were considered but
these were not the dominant factors.

Firms where performance was a greater determinant
in compensation usually had annual or biannual meetings of the
partners to review performance and negotiate income percentages.
In many cases, these meetings would become extremely divisive as
partners would criticize each other publicly. In larger firms,
compensation committees would be set up to assess partners'
performance and make compensation recommendations. A less
divisive method of determining compensation - but still a system
in which performance is subjectively perceived.

The late 60's and early 70's saw the broader use
of performance based systems in which attempts were made to
measure performance via accounting data. Usually, these systems
were not successful and we see relatively few of them today.

As the marketplace for legal services matured,
and competition for bright lawyers who controlled a book of
business increased, firms with traditional lockstep compensation
plans found that either changes had to be made or productive
partners (mostly middle partners) would leave. Rather than
outrightly abandoning their traditional compensation systems,
firms often added bonus pools whose distribution was tied to
individual performance. Another feature which was frequently
added to lockstep plans was the setting up of defined performance
goals which had to be met in order to progress beyond certain
steps on the income progression ladder.

Of all of the various approaches to partner
compensation which we have seen, we could not say that one
approach is better than another. We would judge the merits of any
compensation system based on the following criteria: 1) Is it
perceived to be fair?; 2) Does it recognize all types of
contributions to the firm's success?; 3) Does it encourage
specialization?; 4) Is it understood by those subject to it?; 5)
Does it motivate individuals to behave in a manner which furthers
the firm's goals and objectives?; 6) Is it flexible to meet
changing needs of the firm?; 7) It is generally not desirable to
have small differentials in compensation.

Test your own firm's partner compensation system
by applying these criteria: If you get one or more "no"
answers to these six questions, its time to consider some
changes.

Because the trend in partner compensation is
toward performance based systems, let's look at the essential
elements that such a system must have: 1) Performance must be
properly defined. What factors? What relative importance? Do not
use more than 6 or 7 factors. Some factors overlap: i.e.,
business origination and business perpetuation; administrative
responsibility and associate training; 2) Performance must be
measured and/or judged i.e., use of data and time records. Many
factors can only be judged subjectively; 3) Both long-term and
short-term performance should be considered; 4) A mechanism must
be developed to translate performance ratings into compensation
levels; 5) Partners should receive sufficient feedback to know
which aspects of their performance are strong and which require
improvement.

If all of these sound easy, let us assure you
that it isn't. Lets take another look at the four elements which
are mentioned above: 1) What factors and what weight. List
factors and ask each partner to give his/her opinion relative to
the importance of each factor, scale 1 to 10. Some factors rated
from 1 to 10; 2) Measuring performance is very difficult. Even
with proper financial and management reports. Other factors only
can be measured subjectively. Attempts to credit specific
partners for business origination can lead to conflicting claims;
3) It is difficult to do mechanically. Small variances in
compensation between partners usually are not healthy; 4)
Feedback must be given without identifying specific critics.
Criticism can't be softpedaled.

Rate each partners' total, overall performance on
a scale of 1 to 10 (5 should be average).

Structured

Rate each partner on 7 performance factors on a
scale of 1 to 10 (5 average). Add 7 individual scores to give a
total performance score. Or multiply each rating by a factor
which reflects the importance of that performance element. Then
add resulting scores. Use empirical formula for translating
performance scores into compensation. Set compensation levels
which have meaningful differentials. Number of levels depend on
size of firm. Compensation levels should differ by 10% to 20% for
most firms. Define levels by assignment of points, not dollars.

Hopefully, when you have done this you'll have a
system which will promote the success of your firm and make
everyone happy? Is this possible? All partners happy with their
compensation? Probably not! Some partners always will refuse to
see themselves in the light in which their partners see them.
Some only will grouse - others will leave the firm.